Question
The question is incomplete. The complete question is given as follows:
You consider buying a share of stock. The stock is expected to pay a dividend of $1.50 next year, and dividends are expected to grow by 5% per year forever. What is the stock price now if the stock's beta is 1.1, rf is 6%, and E[rm] = 16%.
Answer
Stock price = $12.5
Explanation:
Using the dividend valuation model, the value of a stock can be determined using this model:
Price = D(1+g)/(r-g)
D- dividend payable now, g- growth rate in dividend, r-return on equity
Return on equity
Re= Rf + β(Rm -Rf)
Rf- risk-free rate, Rm - Return on market portfolio, β- Beta factor
To determine the Stock price we follow the steps below
Step 1
Determine the cost of equity
r = 6% + 1.1 *(16%-6%)
= 17%
Step 2
Determine the stock price
Stock price = 1.50/(0.17-0.05)
= $12.5
Stock price = $12.5
Note
D*(1+g) = Dividend next year. And this has been given as $1.50. So there is no need to apply the growth rate.
